This Could be the Perfect Biotech Portfolio

When it comes to biotech stocks, some investors like to swing for the fences. When that plan works, it feels great. Shareholders of Dendreon (Nasdaq: DNDN), for example, saw their investment rise from $3 in March 2009 to more than $20 in just two months. The stock has doubled again since then, as well. But for every Dendreon, there are many biotech stocks that flame out and end up in the waste bin.

This is why it’s wise to take a diversified approach to biotech stocks, owning risky stocks with lots of potential along with more mature plays that are on a safe and solid growth path. I’ve found four biotechs that run the gamut of the risk/reward spectrum. Taken together, they constitute a model portfolio with considerable upside — if their respective drug development paths can stay on course.

The high-risk/high-reward play

1. Threshold Pharmaceuticals (Nasdaq: THLD)
High-risk plays involve biotech firms that have drugs early in the clinical trial process. Many hurdles need to be overcome before the drugs ever hit the market, but the market value for these companies is often small in relation to the size of the potential opportunity.

Threshold Pharmaceuticals is developing an innovative hypoxia-activated drug, TH-302, for the front line treatment of pancreatic cancer. Hypoxic regions of tumors are areas where oxygen is deprived. Most drugs have a hard time circulating in such environments. TH-302 actually prefers such an environment. Equally important, the drug leaves healthy tissue alone.

Right now, Threshold is focusing on pancreatic cancer, but the technology could be applied to many other types of tumors. TH-302 is still at least three years away from commercial launch. It has shown clear efficacy in the first two phases of clinical testing (though Phase II testing continues), but the all-important Phase III trials are yet to come.

In coming quarters, the stock could get a lift from further solid clinical testing data as well as deeper Wall Street coverage. The company recently appointed Dr. Samuel Sachs as interim chief medical officer. Sachs, who co-founded Jazz Pharmaceuticals (Nasdaq: JAZZ), has deep ties to Wall Street. As TH-302 progresses through clinical trials, Threshold may seek to partner with a large drug firm. It’s hard to peg the size of a potential market opportunity, but it could be significant, well above the company’s current $90 million market value.

Medium risk

2. Intermune (Nasdaq: ITMN)
This biotech stock really caught fire last December when it received preliminary European approval for Esbriet, which treats pulmonary cystic fibrosis. The stock doubled on December 17, 2010 to around $35 before hitting almost $50 in early April 2011. At the time, investors were buzzing that Intermune would benefit from either a buyout or an eventual approval for Esbriet in the United States as well (where it has undergone greater regulatory scrutiny). Momentum investors soon lost patience and shares are back down in the mid-$30s.

The previous move toward the $50 mark was no coincidence. Analysts thought this would be a price offered by a potential suitor. “An opportunistic offer of $50 or more is almost a no-brainer for (companies like Merck (NYSE: MRK) and Astra-Zeneca (NYSE: AZN)),” wrote analyst Alex To at CrossCurrent Research in a late December research note.

Perhaps the most likely suitor would have been Gilead Sciences (Nasdaq: GILD), which decided in December that its own drug to treat idiopathic pulmonary fibrosis (IPF) was ineffective in clinical trials. But Gilead decided to acquire Arresto Biosciences, which has an IPF drug in an earlier stage of clinical testing.

I’ve seen this play out elsewhere. Biotech firms with newly-approved drugs seeking to sell themselves can see shares sizzle. But when no suitor emerges, the stock can lose all of its gains — and more. This is also the case with Savient Pharmaceuticals (Nasdaq: SVNT), which has lost two-thirds of its value from its peak.

Just because buyers fail to emerge for companies like InterMune and Savient right away doesn’t mean they don’t hold real appeal. Big drug companies absolutely need newly-approved promising drugs for their pipeline. They just move too slowly to please the buyout crowd. Both Intermune and Savient, nicely down from their highs, provide a window of opportunity. Buyout or not, Intermune’s fortunes should rise in earnest as European sales begin later this year, with potential U.S. sales coming in a few years.

Low-to-medium risk with solid upside

3. Ligand Pharma (Nasdaq; LGND)
Rather than develop its own drugs, Ligand invests in other biotech firms, generating income from milestone payments and royalties that small firms get from their Big Pharma partners. Ligand likes to focus on early-stage firms needing cash and possessing considerable upside.

Right now, Ligand has a hand in more than 50 companies, about half of which have already progressed their drugs to Phase II clinical trials or beyond.

Jeffrey Cohen, who follows Ligand for C.K. Cooper (and for full disclosure is a friend and former of mine) thinks shares are worth $21 on a sum-of-the-parts basis, including projected royalties, milestone payments and the stakes in various firms that have not yet garnered revenue streams. This target price is nearly double the current value. Analysts at McNicoll, Lewis and Vlak are even more bullish with a $30 price target. “We view LGND as a more de-risked biopharma investment with an unprecedented number of individual shots on goal,” they recently wrote.


4. Celgene (Nasdaq: CELG)
With more than $4 billion in annual sales, this is a mature biotech company continuing to pound out impressive sales for its myeloma drug, Revlimid.

In recent years, management has been pursuing other drugs in clinical testing to prepare for the day Revlimid loses its patent protection. This won’t be for at least another five years, however. As Celgene’s other drugs gain traction, sales and profits are on the rise, projected to climb another 20% to 25% this year and 15% in 2012. Meanwhile, shares have flat-lined around $60 for the past five years after a stunning upward move in the prior five years. Trading at just 15 times projected 2012 profits, this is a reasonably valued growth vehicle in a volatile industry.

Action to Take –> Taken together, these stocks represent a nicely diversified approach that could raise your portfolio higher even if the market and broader economy fail to gain traction in the quarters ahead.

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